by Howard Marks
1
The Most Important Thing Is … Second-Level Thinking
The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom.
BEN GRAHAM, THE INTELLIGENT INVESTOR
Everything should be made as simple as possible, but not simpler.
ALBERT EINSTEIN
It’s not supposed to be easy. Anyone who finds it easy is stupid.
CHARLIE MUNGER
Few people have what it takes to be great investors. Some can be taught, but not everyone … and those who can be taught can’t be taught everything. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time.
The reasons are simple. No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.
Investing, like economics, is more art than science. And that means it can get a little messy.
One of the most important things to bear in mind today is that economics isn’t an exact science. It may not even be much of a science at all, in the sense that in science, controlled experiments can be conducted, past results can be replicated with confidence, and cause-and-effect relationships can be depended on to hold.
“WILL IT WORK?” MARCH 5, 2009
Because investing is at least as much art as it is science, it’s never my goal—in this book or elsewhere—to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.
At bottom, it’s a matter of what you’re trying to accomplish. Anyone can achieve average investment performance—just invest in an index fund that buys a little of everything. That will give you what is known as “market returns”—merely matching whatever the market does. But successful investors want more. They want to beat the market.
SETH KLARMAN: Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us.
In my view, that’s the definition of successful investing: doing better than the market and other investors.
CHRISTOPHER DAVIS: The subtext here is that you must be patient and give yourself ample time—you’re not looking for short-term windfalls but for long-term, steady returns.
To accomplish that, you need either good luck or superior insight. Counting on luck isn’t much of a plan, so you’d better concentrate on insight. In basketball they say, “You can’t coach height,” meaning all the coaching in the world won’t make a player taller. It’s almost as hard to teach insight. As with any other art form, some people just understand investing better than others. They have—or manage to acquire—that necessary “trace of wisdom” that Ben Graham so eloquently calls for.
Everyone wants to make money. All of economics is based on belief in the universality of the profit motive. So is capitalism; the profit motive makes people work harder and risk their capital. The pursuit of profit has produced much of the material progress the world has enjoyed.
But that universality also makes beating the market a difficult task. Millions of people are competing for each available dollar of investment gain. Who’ll get it? The person who’s a step ahead. In some pursuits, getting to the front of the pack means more schooling, more time in the gym or the library, better nutrition, more perspiration, greater stamina or better equipment. But in investing, where these things count for less, it calls for more perceptive thinking … at what I call the second level.
Would-be investors can take courses in finance and accounting, read widely and, if they are fortunate, receive mentoring from someone with a deep understanding of the investment process. But only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.
Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others—both more powerful and at a higher level. Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different.
PAUL JOHNSON: Marks’s comments in this paragraph are excellent. He successfully articulates the critical importance of second-level thinking to investment success. The short discussion that follows offers three excellent examples of the difference between first- and second-level thinking.
What is second-level thinking?
• First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
JOEL GREENBLATT: I hear first-level thinking from individual investors all the time. They read the headlines or watch CNBC and then adopt conventional first-level investment opinions.
• First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
• First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”
Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
CHRISTOPHER DAVIS: This is a good reminder of questions you should always ask yourself when evaluating new investments. It’s easy to forget this in the excitement of a new opportunity.
The difference in workload between first-level and second-level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former.
First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.
That’s not to say you won’t run into plenty of people who try their darnedest to make it sound simple. Some of them I might characterize as “mercenaries.” Brokerage firms want you to think everyone’s capable of investing—at $10 per trade. Mutual fund companies don’t want you to think you can do it; they want you to think they can do it. In that case, you’ll put your money into actively managed funds and pay the associated high fees.
Others who simplify are what I think of as “proselytizers.” Some are academics who teach investing. Others are well-intentioned practitioners who overestimate the extent to which they’re in control; I think most of them fail to tote up their records, or they overlook their bad years or attribute losses to bad luck. Finally, there are those who simply fail to understand the complexity of the subject. A guest commentator on my drive-time radio station says, “If you have had good experience with a product, buy the stock.” There’s so much more than that to being a successful investor.
First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.
Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half. To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?
CHRISTOPHER DAVIS: You can also invert this—in addition to asking yourself how and why you should succeed, ask yourself why others fail. Is there a problem with their time horizons? Are their incentive systems flawed or inappropriate?
The problem is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on. Over the years, many people have told me that the matrix shown below had an impact on them:
PAUL JOHNSON: The concepts in this section are critically important if an investor is going to have the correct viewpoint to deliver superior investment performance. The wisdom espoused in this section alone is worth the price of the book.
You can’t do the same things others do and expect to outperform. … Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently. I conceptualize the situation as a simple 2-by-2 matrix:
Of course it’s not that easy and clear-cut, but I think that’s the general situation. If your behavior is conventional, you’re likely to get conventional results—either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average.
“DARE TO BE GREAT,” SEPTEMBER 7, 2006
The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.
The attractiveness of buying something for less than it’s worth makes eminent sense. So how is one to find bargains in efficient markets? You must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.
“RETURNS AND HOW THEY GET THAT WAY,” NOVEMBER 11, 2002
For your performance to diverge from the norm, your expectations—and thus your portfolio—have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
Those who consider the investment process simple generally aren’t aware of the need for—or even the existence of—second-level thinking. Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers. To consistently achieve superior investment returns, you must be one of them.
JOEL GREENBLATT: The idea is that agreeing with the broad consensus, while a very comfortable place for most people to be, is not generally where above-average profits are found.
2
The Most Important Thing Is … Understanding Market Efficiency (and Its Limitations)
In theory there’s no difference between theory and practice, but in practice there is.
YOGI BERRA
The 1960s saw the emergence of a new theory of finance and investing, a body of thought known as the “Chicago School” because of its origins at the University of Chicago’s Graduate School of Business. As a student there in 1967–1969, I found myself at ground zero for this new theory. It greatly informed and influenced my thinking.
The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk-adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the efficient market hypothesis. (All of these are addressed in the pages that follow.) In the years since it was first proposed, that last concept has proved to be particularly influential in the field of investing, so significant that it deserves its own chapter.
The efficient market hypothesis states that
• There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
• Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.
• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.
• Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.
That’s a more or less official summary of the highlights. Now my take. When I speak of this theory, I also use the word efficient, but I mean it in the sense of “speedy, quick to incorporate information,” not “right.”
PAUL JOHNSON: Marks’s definition of “efficient” is functional and works well with students.
I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct. In January 2000, Yahoo sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions. But that doesn’t mean many investors were able to detect and act on the market’s error.
If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.
PAUL JOHNSON: Here, Marks successfully links market efficiency with second-level thinking. This statement is a very important contribution to investment literature because few commentators have attempted to link academic work on market theory with a pragmatic view of how to actively manage assets.
The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold
views that are different from the consensus and closer to being correct.
SETH KLARMAN: Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.
CHRISTOPHER DAVIS: It is also critical to spend time trying to fully understand the incentives at work in any given situation. Flawed incentives can often explain irrational, destructive, or counterintuitive behaviors or outcomes.
That’s what makes the mainstream markets awfully hard to beat—even if they aren’t always right.
“WHAT’S IT ALL ABOUT, ALPHA?” JULY 11, 2001
The most important upshot from the efficient market hypothesis is its conclusion that “you can’t beat the market.” Not only was this conclusion founded logically on the Chicago view of the market, but it was buttressed by studies of the performance of mutual funds. Very few of those funds have distinguished themselves through their results.
What about the five-star funds? you might ask. Read the small print: mutual funds are rated relative to each other. The ratings don’t say anything about their having beaten an objective standard such as a market index.
